None dare call it regulation

Oftentimes regulatory schemes are nothing but outdated ways of maintaining the dominant market position of incumbent operators or other privileged stakeholders.

Exactly! And in these times where "regulation" is an all-purpose buzzword, it is worth remembering that the "incumbent operators" and/or "priviliged stakeholders" can be regulators themselves. (Matt clearly knows this already.)

The foregoing was Public Choice 101, but it can play out in different ways. One obvious example is when a regulator uses a crisis as an opportunity to aggrandize its own position within the regulatory system. Exhibit A is Sheila Bair's recent positioning of herself as the choice to run the to-be-established "bad bank" instead of Ben Bernanke or the tax-weakened Tim Geithner, notwithstanding her personal and agency's lack of experience handling or regulating the types of assets to be held by any such "bad bank." But another, more subtle example is when a regulator successfully defines "regulation" as "whatever we are already doing."

This latter example is, in my opinion, the untold story of the regulatory regime during the Bush administration. Megan's old co-blogger Mindles H. Dreck summed it up well in the wake of the meltdown that followed the Lehman bankruptcy:

Another notion out there is that regulation has been lax during the Bush years. This is simply untrue. Between the post-Enron documentation frenzy and the post-Patriot act money-laundering frenzy, regulators have staffed up and been empowered over the last years in ways I have never seen in my 20 year career. In fact, in ways my colleagues with 40-50 years in the industry have never seen. Compliance departments have staffed up to 3 or 4 times their prior levels to deal with the added regulatory inquiries, requirements and monitoring programs.

...No, there has been no shortage of regulation, just a shortage of regulation that has to do with systemic safety and solvency. Regulators have been obsessed with e-mail retention, policies, procedures, desk manuals, 'know-your-customer' files, control self-assessments, speed of audit follow-up, even encouraging staffing up for 'regulatory risk'!. Most of the regulatory focus has been on matters clearly designed to support private litigation, such as retention of documents and correspondence, and policy description and attestations (like Sarbanes-Oxley).

Meanwhile, not one of them noticed that Tier 1 Capital had become a bankrupt concept, or that structure substitutes for leverage.

We have been force fed a super-sized trucker meal of stupid paper-pushing requirements while the basic risks of asset leverage went unaddressed. Frankly it was symptomatic of the Lawyering-down going on in this the country, where process and paper trail takes precedence over substance and ethics. If you think this idiocy is somehow the product of only one party, I politely submit your partisanship has severely clouded your judgment.

...Process has come to dominate the management of public companies at the expense of advancing the underlying business. As any executive or director of a public company knows, the intersection of Bush-era regulation, populist and ignorant press coverage, and the conservative advice of lawyers who have seen the criminalization of business judgment have driven boards and management to the last defense available to them when tort lawyers or prosecutors come calling, that they ran a good process. The result is that directors spend their time on essentially bureaucratic matters instead of understanding the strategy of the business and guiding management in its execution. Worse, the most entrepeneurial directors are quitting out of boredom or crowded out to make room for CPAs and lawyers to staff the audit and compensation committees.

...The second problem with accounting is Sarbanes-Oxley. The chief complaints against this law revolve around the cost of compliance, and that it is driving business to overseas capital markets, or deterring companies from going public. While these are all meritorious indictments, my own objection is to the impact of the law on the culture of business. In the production of financial statements, SarBox quite literally elevated process -- that word again -- to the same stature as outcome. Whereas before it was only necessary to produce financial statements that neither misstated nor omitted a material fact and were true in all material respects, now one must do that according to a process that is under "control." Your auditors audit both the statements and the process. It is therefore possible to produce legally accurate financial statements and still be liable for not actually running your company in a way that ensures that you pass the process audit. Whether intended by Congress or not, the de facto requirements of SarBox demand that "business processes," which are pretty much everything that involve financial transactions (buying, selling, manufacturing, invoicing, collecting, paying, order-taking, the administration of computer systems, and so forth), must be structured in a way to avoid the possibility of "conflicts." That can significantly increase the people necessary to do a particular task, the time it takes to do it, and the level in the organization at which decisions about "responsibilities" may be made. The net effect of this elevation of process is to confine decision-making, bureaucratize authority, and destroy risk-taking and creativity at all but the highest levels. It is devestating to the culture of American business, heretofore the greatest engine of wealth the world has ever seen.

And these complaints correlate with those made by Harry Markopolos about his experiences trying to get the SEC to catch Madoff: the agency could not overcome its own narrow habits even when the world's biggest Ponzi scheme was handed to it on a silver platter.

"Getting tough on Wall Street" will not help if you don't know what you should get tough about. I can provide one example: the current SEC inspection regime for investment advisers is famous for focusing on nits in process and paperwork - and given the voluminous requirements for each, it is virtually unavoidable for an adviser to have some. (According to this compliance firm, over 95% of adviser inspections find at least one deficiency. This old SEC report has a slightly lower figure - just under 90%.) And recently, the New York branch of the SEC decided to get tough...by massively increasing the demands for paperwork advisers were required to produce (on very short notice) for routine SEC inspections. If there is any evidence that these increased demands have led to the SEC finding more substantive violations (as opposed to self-executing violations caused by the failure to produce all the paperwork in time), I haven't seen it. Treating everyone like a criminal does not, by definition,increase one's ability to distinguish the guilty from the innocent.

And this was the regulatory regime to which Bernard Madoff should have been subject! There are good arguments to be made in favor of regulation of hedge funds, but the adviser registration rule (which was struck down in court in 2006, and a variation of which has been re-proposed in Congress) would merely have plugged hedge fund advisers into yet another pre-existing regime focused on paperwork and process instead of substance. In this environment, we can't afford another Sarbanes-Oxley focus on "process" which harms everybody.

I hope to write more in the upcoming weeks about the substance that regulators should focus on, but one thing is clear: we need change we can believe in, not more of the same.

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